How Foreign Tax Credits Work

Credit Eligibility

In order to be eligible for the foreign tax credit, a taxpayer must meet each of these four requirements:

The taxpayer was personally imposed taxes by a foreign country;

The taxpayer actually paid the full amount of those taxes or had it accrued;

The tax was legal and is considered an actual tax liability, not a fine, surcharge or other non-tax payment; and

The tax must be an income tax, not a sales, property or other excise tax [source: IRS].

Married couples who file a joint tax return can claim the credit on any eligible taxes paid by either spouse. The total amount of the eligible credit is also reduced by any sums that are eligible for a foreign earned income or foreign housing exclusion [source: IRS].

A particular foreign tax payment will qualify for the credit only if it isn't refundable and not used to subsidize someone else's tax liability. The tax must also be paid to a country that hasn't been designated by the Secretary of State as one that repeatedly provides support for acts of international terrorism, that the U.S. has diplomatic relations with and for whom the U.S. recognizes the country's government [source: IRS].

A tax deducted from wages is a good example of the type of payments intended to be covered by the credit. That includes money paid to U.S. possessions like Puerto Rico and American Samoa [source: IRS].

Additional Credits

Taxpayers who earn money from certain countries with which the U.S. has a tax treaty in place may be eligible for additional tax credits. These credits are separate from, and in addition to, the money covered by the foreign tax credit. A full list of the countries currently covered by such treaties — which includes Australia, France, Germany, South Africa, Spain and the United Kingdom — is available in the IRS's website [source: IRS].